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Performance measurements and the treatment of goodwill.

Performance Measurements and the Treatment of Goodwill

Managerial planning/decision making is often categorized into technical, tactical and strategic levels. These levels form a hierarchy, each reporting to the other, with the strategic managers reporting to the stockholders. Many stockholders, especially those of publicly traded companies, are outside parties and, therefore, must rely on financial reports produced for external consumption to evaluate their investment.

Financial reports for external consumption contain historical information produced according to generally accepted accounting principles. They show status of the company and results of recent operating activities. Even though the past may be indicative of the future, resource decisions reflected in the balance sheet more accurately relate to future expectations. Because strategic managers make decisions that (1) involve significant resources over a long period of time, (2) affect the company as a whole, (3) relate to the long-range future of the company and (4) are somewhat dependent on outside forces for success, there is a time lapse between a strategic decision and its measurable success or failure. This time lapse and distortions in the balance sheet prevent reported values from providing good information to measure performance of strategic managers.

Because the balance sheet is a primary financial report which is used by stockholders or potential investors to evaluate performance of strategic decision-makers, its accuracy and communicative ability are critical. Historical cost as a basis for recording has been controversial for a long period of time because distortions from current values are reported. Current value accounting, inflation accounting, disclosure of replacement cost, and focus on cash flows are all manifestations of attempts to resolve this problem. Even though problems related to historical cost have not been solved, they are not the only ones which create distortions in the balance sheet.

One of the distortions reported in the balance sheet related to the future is goodwill. The increasing number of business combinations, public expectations of the future and generally accepted accounting principles related to goodwill have combined to create significant measurement problems. Although much attention has been given to goodwill by analysts in the marketplace, little, except the recording of purchased goodwill, has been reported in the balance sheet which accountants offer as a measuring instrument. The purpose of this article is to consider the concept, measurement and recording of goodwill as it distorts financial reports relevant to the evaluation of performance of strategic decision-makers.

Concept of Goodwill

Webster's Third New International Dictionary defines goodwill in four ways:

1) Kindly feeling: well wishing,

benevolence, friendliness;

2) The custom of a trade or business:

the favor or advantage that

a business has acquired beyond

the mere value of what it sells

whether due to the personality

of those conducting it, the nature

of its location, its reputation

for skill or promptitude, or

any other circumstance incidental

to the business and tending

to make it permanent;

3) The capitalized value of the excess

of estimated future profits

of a business over the rate of

return on capital considered

normal in the related industry;


4) The excess of the purchase

price of a business over and

above the value assigned to its

net assets exclusive of


Accounting Research Study No. 10 states that probably the most relevant concept of goodwill in today's business environment dates to its future earning power. This concept is also supported in FASB's Discussion Memorandum (D.M.) No. 9, which states that there are two broad views of goodwill:

1) Goodwill represents excess expected


2) Goodwill represents intangible

resources of a company's above

average strength in certain

areas, i.e., technical skills and

knowledge, management, marketing

research and promotion,

etc., that cannot be separately


Actually these are not mutually exclusive since these intangible resources allow a company to produce above expected normal earnings.

Inherent Goodwill

To analyze the concept of goodwill from an accounting standpoint, two types of goodwill must be considered. These are inherent goodwill and purchased goodwill. Inherent goodwill is the presence of goodwill which must be inferred from external manifestations. The nature of an asset becomes immeasurably transformed when it functions within the business as a part of a whole. Goodwill is actually not a different asset but rather results from the integrated use of all assets.

Strategic decisions which perpetuate inherent goodwill are known to the experienced owner who chooses to hold stock rather than liquidate it at the offer price of another potential owner. Inherent goodwill, discounted for the riskinvolved, is measured in the market-by-market price of stock. The difference between total equity as reflected in this price and the equity on the books includes historical cost distortions as well as goodwill, but these distinctions are not relevant since inherent goodwill is included as the assets are used in the business and not as deprival values.

Continuous growth of inherent goodwill is fueled by its own momentum. In an ongoing business its current value is reflected in resources expressed on the balance sheet combined with this momentum while results of past goodwill are reflected in greater than normal operating results.

Goodwill is a phantom asset. Increased activity in mergers and takeovers has verified its existence because an unusual amount of recorded goodwill according the GAAP has resulted. According to Standard & Poor's Compustat Services, Inc., intangible assets on the books of 5,500 companies jumped 37% in 1984 to $55.3 billion. The culprit: takeover fever. The market does not dismiss goodwill anymore. Investors do have a task to distinguish the valuable goodwill from the psychological overvalued goodwill resulting from bidding wars. When an overexcited management purchases a business at an overvalued price, the additional dollars are recorded as goodwill.

In a product industry, establishing a brand image is very expensive, takes a long period of time and carries a high risk of failure. There is a lot of very enduring goodwill in brand loyalty which is not expressed on the balance sheet until after a takover when goodwill is recorded.

In a service industry, the purchase price of a business will usually be more than the fair value of the net tangible assets and identifiable intangible assets acquired. This excess represents income generating potential created by an experienced management team and an established customer base. In many businesses, such as media, the "franchise" or ability to do business is much more important as an ingredient sold than the hard assets like printing plants. Many other service type businesses are the same. Success in a service business appears to be more dependent on customer goodwill than in a product business, and, because the service component of GNP in the United States has been increasing, goodwill as a marketable asset is increasing.

Purchased Goodwill

When goodwill is purchased, the seller has a preference for liquidity, whereas the buyer believes that the net assets received will yield more than the resources expended. The transaction therefore gives added economic value in that both benefit. The buyer considers (1) opportunity cost of acquiring instant superprofitability rather than building from scratch, (2) savings achievable by economics of scale, (3) possible elimination of competition, and (4) value of combining know-how and skills. None of these applies to the target entity on its own. Only when combined with the new owner does this emerge. The buyer is interested in the business as an entity and in its future potential performance and has no need to view the assets separately, while the seller is looking at the current market value of that future. His preference for liquidity negates the desire to wait for the future to materialize. The seller is willing to take less than the present value of the full future potential because he is giving up the risk involved, whereas the buyer is willing to pay something for goodwill but not the full present value of future potential because of the risk assumed. The buyer and the seller are looking at different things.

The different natures of purchased and inherent goodwill can also be seen in terms of time. Inherent goodwill is reflected implicitly in the balance sheet as the current status of past strategic decisions. Purchased goodwill, by contrast, represents the additional amount over and above the values reflected in the target company's balance sheet which the acquiring company pays to receive benefits from the combination in the future. Goodwill is therefore indistinguishable from any other investment when calculations are made of the net present value of future revenue flow. The acquirer is looking at the whole of the company purchased, and the necessity of separating goodwill from other assets is not paramount. Subsequently, the value of purchased goodwill is reported at historical cost and has the usual distortions created by using the historical cost basis.

Much inherent goodwill is purchased by one stockholder from another. Such goodwill is measurable but is not recorded, and, because the transaction occurs between two owners, the price paid relates to a portion of the ownership rather than to the total ownership. Investors continually evaluate future potential and use various valuation formulas as they set the market price, but these are not disclosed in financial reports.

Recording Goodwill

Goodwill is recorded on the books of a company when a new entity is purchased. Accounting Research Bulletin No. 24 [1944] and Accounting Principles Board (APB) Opinions No.16 and 17 [1970] addressed important issues relating to purchased goodwill, i.e., creation of goodwill, measuring goodwill at acquisition and subsequent accounting treatment of goodwill. However, no strict guidelines were developed. Rather, options discussed for the treatment of goodwill depended on individual circumstances.

Several problems have continually persisted concerning recording goodwill. These are (1) the allocation of the purchase price to assets vs. goodwill, (2) the potential allocation differences between GAAP and tax considerations, (3) excessive goodwill recorded, and (4) amortization and write-offs.

Allocations of Purchase


There are basically two methods of allocating the purchase price of an acquired corporation to goodwill for recording purposes. These are the residual method and the direct method. The residual method, stated in APB Opinion No. 17, records goodwill as the difference between the purchase price of a group of assets (company) and the current values of each of the tangible and identifiable intangible assets acquired less liabilities assumed. The direct method does not treat goodwill as simply a residual amount. It values goodwill according to a specific valuation method, as any other asset.

Statement of Financial Accounting Concepts No. 1 [1980] states that one of the primary objectives of financial statements and financial statement reporting, of which goodwill is a part, is that of decision usefulness to investors, creditors and other interested parties. If goodwill as reported in financial statements is to be a reliable useful part of those statements, it must be recorded as precisely as possible. SFAC No. 3 defines an asset as "probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." Also, SFAC No.5 states that in order for an item to be recognized as an asset it must meet four criteria:

1) The item meets the asset


2) The item can be measured with

sufficient reliability.

3) The item is important in user


4) The item is representationally

faithful, verifiable and neutral.

If goodwill is an asset as defined in Statement on Financial Accounting Concepts No. 3, it should be able to be measured and valued independently.

Tax Effects of Goodwill


An additional complication is caused by the failure of the tax law to correspond with generally accepted accounting principles. Accounting Principles Board Opinion No.16 proclaims that any difference between the accounting and the tax bases is not a timing difference requiring tax allocation. However, while asserting that differences in tax and GAAP asset bases are not timing differences, APB Opinion No. 16 also states: "Estimated future tax effects of differences between the tax bases and amounts otherwise appropriate to assign to an asset are some of the variables in estimating fair value."

It becomes apparent that the market values assigned to assets are to be modified by the tax benefit of losses caused by a lack of correspondence between the GAAP asset basis and the tax asset basis. GAAP measures goodwill as a residual or excess of the purchase price over the market value of the tangible assets and identifiable intangible assets less liabilities assumed; whereas, the tax treatment assigns an appraisal value to goodwill similar to other assets and then prorates differences between price paid and total estimated values assigned to the non-monetary assets. Because goodwill is not deductible for tax purposes, discrepancies may result.

Excessive Goodwill


In certain corporate takeovers, when the purchase price exceeds the current value of the tangible and identifiable intangible assets less liabilities assumed (net assets) the amount allocated and recorded as goodwill does not completely represent real economic substance. In these cases the purchase price may exceed the current economic value of the purchased corporation as a whole. The amount recorded as goodwill, using the residual method, exceeds the difference between the value of the corporation as a whole and the value of the corporation's net assets.

This occurrence may be particularly prevalent in what might be called "hostile" corporate takeovers - those in which one corporation takes over another against the wishes of many stockholders and/or management, but does so by making an offer that the majority of stockholders simply cannot refuse. When this type of takeover occurs, the amount of goodwill is overstated, total assets and equity are overstated, and the real current value of the firm is therefore overstated.

Amortization and Write-off

An additional problem related to recording goodwill is the amortization and write-off. Some firms set up a systematic write-off over a specialized period of time. Some firms have a policy not to amortize goodwill unless circumstances arise in which there is a permanent reduction in of income generating potential of an operating entity. If a permanent reduction has occurred, it is charged to an extraordinary item in the period in which it arises. These varying policies for write-off make goodwill reflected in the balance sheet a very inaccurate measure of future expectations of strategic decisions even if the measure was good when it was initially recorded.


Measurements of

Strategic Managers

How goodwill is valued and disclosed and how inherent goodwill is explained and distinguished from unamortized purchased goodwill reflected on the balance sheet are subjects of needed empirical research. Activity by analysts suggests that there are several potential valuation models. Market price of stock, discounted expected future earnings and valuation formulas appear to be in current use as buyers and sellers effect transactions in the market place. The scope of this article does not include suggestions for solutions to this problem.

However, because inherent goodwill is an indication of the value of wise strategic decisions not yet materialized and is not valued or disclosed in accounting financial reports and because purchased goodwill is reflected as an unamortized prior value which may not measure future expectations at the balance sheet date, the accounting financial reports, when inherent or purchased goodwill is present, offer inadequate information to measure performance of strategic decision-makers. Distortions caused by using historical cost complicate the problem, but this problem is generally known to users. Measurements done by analysts in the market are four different purposes and are not normally available to stockholders who must measure performance of their strategic managers. Until better valuation and disclosure of inherent goodwill and purchased goodwill is included in balance sheets or accompanying footnotes, stockholders must continue to rely on the past rather than the current status for measuring future expectations.


Technical, tactical and strategic levels of management form a hierarchy, and strategic levels report to stockholders who may be outside the firm. Such stockholders depend on the balance sheet to reflect current status of strategic decisions which have been made but which have not materialized. This information is more relevant to future expectations than income statement information because good performance in the past may not be continued in the future. However, in order for balance sheet information to be useful for measuring performance of strategic managers, explanations which permit interpretation of the figures relevant to the future must be included.

Various disclosures are now included which help with distortions caused by historical cost and variations permitted in GAAP, but no disclosure is included to help with the valuation of inherent goodwill apparent at balance sheet date. Purchased goodwill shown on the balance sheet is usually not a good measure because of problems of allocation, excessive offers, and varying amortization policies. Because balance sheet values of goodwill are usually unamortized past values, they may not measure future expectations at balance sheet date even though strategic decisions are expressed in resource values on the balance sheet and accompanying footnotes. Improved valuation and disclosure of goodwill, both purchased and inherent, at the end of the fiscal year as part of the balance sheet included in the attestation function is needed to help stockholders make informed judgments about the performance of strategic managers.

Clyde E. Herring and Dora R. Herring teach in the School of Accountancy at Mississippi State University.
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Author:Herring, Clyde E.; Herring, Dora R.
Publication:The National Public Accountant
Date:Apr 1, 1990
Previous Article:Calculating deferred tax assets.
Next Article:Federal Taxation of Income, Estates and Gifts, vol. 2, 2d ed.

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